According to U. GAAP, unless signs of significant influence are present, an investor owning less than 20 percent of the outstanding shares of another company reports the investment as either a trading security or available-for-sale security.
In contrast, an investor holding 20 percent or more but less than or equal to 50 percent of the shares of another company is assumed to possess the ability to exert significant influence. Unless evidence is present that significant influence does not exist, the equity method is applied by the investor to report all investments in this 20—50 percent range of ownership.
Question: One company holds shares of another and has the ability to apply significant influence so that the equity method of accounting is appropriate. What reporting is made of an investment when the equity method is used? Answer: When applying the equity method, the investor does not wait until dividends are received to recognize profit from its investment. Because of the close relationship, the investor reports income as it is earned by the investee.
Income is recognized by the investor immediately as it is earned by the investee. Thus, it cannot be reported again when a subsequent dividend is collected. That would double-count the impact. Income must be recognized either when earned by the investee or when later distributed to the investor, but not at both times.
The equity method uses the earlier date rather than the latter. Eventual payment of a dividend shrinks the size of the investee company. Thus, the investor decreases the investment account when a dividend is received if the equity method is applied. No additional income is recorded. Companies are also allowed to report such investments as if they were trading securities. However, few have opted to make this election. If chosen, the investment is reported at fair value despite the degree of ownership with gains and losses in the change of fair value reported in net income.
Question: In applying the equity method, income is recognized by the investor when earned by the investee. Subsequent dividend collections are not reported as revenue by the investor but rather as a reduction in the size of the investment account to avoid including the income twice. No evidence is present that provides any indication that Big lacks the ability to exert significant influence over the financing and operating decisions of Little.
Thus, application of the equity method is appropriate. What recording is appropriate for an investor when the equity method is applied to an investment? Answer: The purchase of 40 percent of Little Company for cash is merely the exchange of one asset for another.
Thus, the investment is recorded initially by Big at its historical cost. Figure Ownership here is in the 20 to 50 percent range and no evidence is presented to indicate that the ability to apply significant influence is missing. Thus, according to U. GAAP, the equity method is applied. Because earning this income caused Little Company to grow, Big increases its investment account to reflect the change in the size of the investee. Big has recognized the income from this investee as it was earned.
Consequently, any eventual dividend received from Little is a reduction in the investment in Little account rather than a new revenue. The investee company is smaller as a result of the cash payout. This total does not reflect fair value as with investments in trading securities and available-for-sale securities. It also does not disclose historical cost.
Under the equity method, the asset balance is a conglomerate of numbers. When the equity method is applied to an investment, what is the appropriate recording of an eventual sale? Answer: An investment reported using the equity method quickly moves away from historical cost as income is earned and dividends received.
All investments in the stock of another company—where ownership is no more than 50 percent—must be accounted for in one of three ways depending on the degree of ownership and the intention of the investor. At some point, an owner can gain enough equity shares of another company to have the ability to apply significant influence. Use of the equity method then becomes appropriate.
Significant influence is difficult to gauge so ownership of 20—50 percent of the outstanding stock is the normal standard applied in practice. However, if evidence is found indicating that significant influence is either present or does not exist, that takes precedence regardless of the degree of ownership. Investor companies will use the equity method to report their investments in the investee company when they have:.
The investor company would report the investment as a one-line consolidation — one line on the income statement, balance sheet and cash flow statement. The investment on the balance sheet would reflect at the original cost, then retained earnings would be added over time. In most cases, the balance sheet does not reflect the fair value of the investment. The Accountant Online. The line is below tax and shown net of taxes. On the balance sheet, a long-term asset shows the original purchase price plus any reinvested earnings to date:.
On the cash flow statement, the equity income of 1,MM is subtracted in the cash flow from operations , and usually the dividends received are added to the cash flow from operations there is scope under IFRS to add the dividends received to the cash flow from investing activities. The dividend accounting is confusing as many people want to put the 6. However, Goran has already taken Remember, when a public company pays a dividend its stock price drops.
Investor companies will use the equity method to report their investments in the investee company when they have: Significant influence but not control.
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